Having traded for years almost oblivious to the notion of risk, China's bond market, Asia's biggest outside Japan, has begun exhibiting characteristics of a genuine credit culture, with onshore investors demanding higher premiums for weak borrowers.

In the past, investors had operated under the belief that the state would always step in to prevent a default.

But a recent default of a credit product, and growing worries over the proliferation of a shadow banking system extending off balance sheet loans, has made them question old assumptions.

Hence, lenders have begun differentiating on the basis of industry fundamentals, the degree of state support and balance sheet size, making the credit curves steeper as the gap between the strong and weak names widens.

"There is no dearth of potential defaulters. But, when there is confidence of a bailout there is no fire sale even in the stressed names, because of confidence that principal will be repaid despite missed coupons," said Becky Liu, Standard Chartered strategist based in Hong Kong.

"The situation is starting to change."

In January, AAA-rated Beijing State Owned Asset sold bonds carrying a coupon of 6.48 percent, 242 basis points more than a coupon paid by AA-rated Ningxia Baota Petrochemical.

Similar bonds sold in December showed a narrower gap between top-tier and second-tier issuers.

Shaanxi Coal, rated AAA, sold 2018 bonds at a coupon of 6.48 percent, but AA-rated Anhui Foreign Economic Construction had to pay just an extra 132 bps for its 5-year bonds.

But while the trends are positive, the situation really is only starting to change, as analysts say most investors still nurture belief that Beijing will step in rather than allow a default that could drain confidence from the market.

DIFFERENT YARDSTICKS

Unlike in mature markets, where a AA rating is considered strong, investors deem anything below AAA in China to be weak.

The spread between high- and low-risk borrowers , according to Thomson Reuters benchmark curves, has widened to a 21-month high of 105 basis points now, from around 70 bps in mid-2013, when China's money markets suffered a short lived liquidity squeeze that sent tremors well beyond its borders.

Yet, China's AA-rated bonds currently yield 10-15 percent more than the top-rated borrowers, which is still less than half the spread between top-tier and speculative grade bonds in Western countries.

Since mid-January, the gap has widened by 20 basis points after Industrial and Commercial Bank of China, the world's largest bank by assets, said it would not finance a repayment to investors in a troubled off-balance-sheet investment product that it helped to market.

In the end an unnamed investor stepped in with a bailout, though local media had previously reported that the local government, ICBC, and the trust firm would share the costs of a bailout.

Worries intensified as 3 billion yuan ($496.20 million) high-yield investment product, backed by a loan to a debt-ridden coal company, failed to repay investors when it matured on Jan. 31.

This month a high yielding investment product sold via China Construction Bank, the country's second biggest lender, failed to repay when it matured on Feb. 7.

Negotiations are ongoing over the return of funds to investors in the product created by Jilin Province Trust Co Ltd and backed by a loan to a coal company, Shanxi Liansheng Energy Co Ltd.

These upsets come on the heels of a report by China's state auditor that showed an alarming build-up in local government debt, and have kept investors on the edge about debt servicing in the world's second largest economy, as it grapples with excess capacities in certain sectors.

There are now fears that some debt obligations may not be met since the money was used for building non-lucrative infrastructure.

Authorities have tried to calm these anxieties with assurances the National Development and Reform Commission (NDRC) will pay close attention to local government debt issues providing them with investment guidance.

Bond investors are also playing their part.

"Local investors are doing more due diligence and analyzing the degree of state support, as well as other credit specific factors in their analysis of credits," said Desmond Fu, rates strategist with Western Asset.

Still, there is unfinished business as the premiums demanded by onshore investors lag those that exist in offshore markets.

The spreads between the 5-year bonds from China Vanke , the country's biggest property developer, and those from a smaller builder Gemdale, is only 100 basis points in the onshore market, which is half the difference prevailing in the dollar bond market.

Gemdale's offshore bond due in 2017 trades at a yield of 6.78 percent compared with 4.78 percent for the slightly longer dated Vanke 2018.

The distinction is because of the difference in access to bank finance as the People's Bank of China (PBOC) tries to rein the shadow banking sector, potentially choking off small builders from funding.

"The PBOC is watching bank lending carefully, and that's the environment where the credit spreads should widen as the market tries to figure out who has back up credit if they need it," said Cliff Tan, East Asian Head of Global Markets Research at Bank of Tokyo-Mitsubishi UFJ.

He said that this credit differentiation between competitors on the basis of size was evident in many sectors.

"It is starting to behave like a credit market. The degree to which credit risk is priced in China waxes and wanes over time - we hope for China's sake the trend is increasing."